Market analysts are beginning to point out that - absent the
long-term interest rate "bet" embedded in fixed rate bonds -
corporate loans outperform high yield bonds as pure credit
Portfolio managers and market commentators have traditionally
approached investment strategy as a choice between stocks and
bonds, while we have argued that it deserves a more nuanced view.
Since bonds contain an embedded bet that interest rates will either
remain flat or go down, in assessing their returns over time you
have to separate out the return an investor receives for taking
credit risk from whatever return they get - plus or minus - from
that bet on the direction of interest rates.
My premise - and that of many others active in the credit
markets - has been that corporate loans, which are senior, secured
and have adjustable rates, provide a higher and more dependable
return as a
instrument than high yield bonds, especially once the impact of the
interest rate bet is removed (see
A Barclay's Capital chart, published by Randy Schwimmer of
Churchill Financial in his weekly review
On the Left
, makes the point very clearly (see
). It shows how high yield bonds have lagged the return on loans
considerably during the past year, once you remove the effect of
the run-up in Treasury bond prices. Since the run-up in Treasuries
represents the "pure" return on taking interest rate risk, the
remaining return is what investors receive for taking credit risk
This has big implications for investors - especially high yield
bondholders - trying to decide what to do going forward. If a big
portion of the return we have enjoyed over the past year or so (I
say "we" because the author is a holder of both high yield bonds
AND senior secured loans) has been due to the once-in-a-generation
drop in interest rates to current levels, then it stands to reason
we won't be enjoying that high-octane boost to our returns in the
future. In fact, if and when interest rates turn back up, that will
be a big drag on bond returns, rather than a boost.
That means investors in high yield DEBT - loans as well as bonds
- should be basing their decision on what the return on taking
is likely to be for each instrument, going forward, and not be
influenced by what sort of extra juice the decline in interest
rates may have provided in the past.
As a pure credit instrument, the loan asset is far superior to
the bond, since it ranks ahead of bonds in default or bankruptcy,
and is secured by real assets rather than being unsecured and, in
some cases, legally subordinated, as most high yield bonds are.
(During the depths of the credit crisis, some high yield bonds were
secured, in order to induce investors to buy them, but that was
largely short-lived.) As a result of their greater protection and
higher recoveries, loans historically have experienced less than
half the credit losses as high yield bonds.
Better credit, higher yields
Ironically, despite their better credit performance, loans yield
about the same - at equivalent levels of credit risk (i.e.
double-B, single-B, etc.) - as bonds stripped of their interest
rate bet return component. In other words, if a 10-year bond pays
8%, but 2% of that is the payment for taking a 10-year interest
rate "bet" (and we know it is, if the "risk free" 10-year Treasury
bond yields just over 2%), then the bond-holder is being paid 6%
(i.e. 8% minus 2%) for taking the credit risk of the issuer. An
equivalent loan probably yields about 6%, with no interest rate
"bet" because the rate is floating and resets every three months.
Since credit costs, whatever they turn out to be in absolute terms
(0.5%, 1%, 2%..........etc. depending on default rates) will always
be lower for loans than for bonds, because loans recover more than
bonds at whatever the default rate, then from a pure credit return
standpoint, loans are the better buy.
But there's more. Since loan coupons are priced off a floating
base rate (usually 3-month LIBOR), loans will provide a hedge
against rising interest rates (the opposite of bonds, whose value
will drop as rates rise.) So just as fixed-rate bonds were a very
smart investment to hold during the 30 year secular drop in
interest rates (and inflation) from the mid-teens in the early
1980s to close to zero now, floating rate loans will likely benefit
big-time if the next few decades see a rise in rates and inflation
as our government wrestles with financing its huge projected
"Equity yields" anyone?
If you take away the interest rate bet, corporate debt with a
predictable 5-6% return looks pretty attractive in an environment
where equity returns have been highly volatile and the economic
future seems to be fraught with uncertainty. But a major attraction
of equity, which induces many conservative long-term investors to
hold their breaths and buy stocks despite the risks, is the belief
that it is the only way to hedge against inflation and rising
interest rates. And compared to "fixed income" bonds, it is. But
floating rate loans, with a predictable yield of 5 or 6 percent,
plus floating rates that effectively hedge against rises in
interest rate and inflation, look a lot like an "equity return" to
Readers have asked for possible ways to invest in floating rate
from ETF Connect, the guide to closed end funds, allows you to
click on "senior loans" to obtain a list.
[Editor's Note: The screen turns up the following corporate
loan closed-end funds: [[BGT]], [[BHL]], [[BSL]], [[EFR]], [[EFT]],
[[EVF]], [[HCF]], [[FCT]], [[FRA]], [[FRB]], [[JFR]], [[JRO]],
[[NSL]], [[PHD]], [[PPR]], [[TLI]], [[VTA]], [[VVR]].]
No specific stocks mentioned; author does own a number of HY bond
and loan funds, including Eaton Vance, Black Rock, Fidelity,
Nuveen, Third Avenue and PIMCO.
'Sell the News' Is Order of the Day